Deepak Narula hit bottom in 2007 when investors pulled money from his hedge fund, leaving him to unwind mortgage bond bets in a frozen market that would have made money if he’d just held on a few more months.

Five years later, Narula, 49, is at the top of the best-performing category of funds. Metacapital Management LP, the New York-based firm he founded in 2001 after leaving Lehman Brothers Holdings Inc., is up 34 percent this year, almost 10 times the industry average. Since restarting in July 2008, returns exceed 500 percent and the firm has expanded to oversee $1.4 billion.

“Mortgage funds generally are doing fabulously well, but he’s outperforming everyone,” said Rael Gorelick, co-founder and principal of Charlotte, North Carolina-based Gorelick Brothers Capital LLC, a $250 million fund of mortgage hedge funds invested in 20 managers. He’s “creative, smart, experienced and can play with two hands: This is his time.”

Narula has built his recent run on predicting how the Federal Reserve, the Obama administration and financial industry would react to the worst housing crash since the 1930s. He’s outpacing competitors by investing in both government-backed securities and riskier property debt, profiting from buying bonds that rallied as real estate recovered, and trading around government attempts to stoke refinancing.

Hedge funds focusing on mortgages returned 17 percent this year through September, according to data compiled by Bloomberg, the best performing of 18 groups. That’s almost five times the 3.6 percent gain for the industry, the data show. Some of the largest firms are faring even worse.

Brevan Howard

Brevan Howard Asset Management LLP, Europe’s second-largest hedge-fund manager, posted a 1.6 percent gain this year in its flagship $25 billion fund, according to a person familiar with the returns. John Paulson, who made $15 billion in 2007 betting against subprime mortgages, has lost 14 percent this year in his Advantage Plus Fund.

By contrast, Pine River Capital Management LP’s $3.4 billion fixed-income fund, which like Narula invests in a various types of home-loan debt, has gained 29 percent this year, according to a performance update sent to investors.

LibreMax Capital LLC, the firm founded by former Deutsche Bank AG trader Greg Lippmann, who benefited in 2007 from the subprime-mortgage collapse, is up about 16 percent, beating peers that focus on non-agency bonds, such as subprime and commercial property securities that don’t have government backing, according to a person briefed on the returns.

Narula, whose 12-person firm occupies a sparsely decorated 38th floor office overlooking Central Park, declined to comment on his returns, which were provided by his investors and letters sent to them obtained by Bloomberg News.

Subprime Debt

Those communications show he made money this year by buying bonds ahead of the Fed’s latest announcement of purchases; targeting securities with protection against refinancing as President Barack Obama’s administration expanded programs to help homeowners get cheaper loans; and increasing holdings of subprime debt, after avoiding it last year when it slumped.

The New Delhi, India, native, who came to the U.S. as a graduate student in 1985, started trading at Metacapital in January 2002 in a very different mortgage market.

Metacapital -- which Narula said he named as a reference to transformation -- grew to $750 million within three years as he posted annual returns from 7.7 percent to 17.1 percent. He navigated 2003 as homeowner refinancing set records and bond markets swung as the Fed began signaling it would end its efforts to lift the economy out of the last recession.

Underwriting Standards

Returns dwindled in 2005 and 2006 as the Fed’s then Chairman Alan Greenspan raised rates, making borrowing more expensive for investors. At the same time, bond buyers were pouring cash into risky debt, driving down yields.

Narula, seeing the decline in underwriting standards, began in January 2005 to bet against bonds tied to borrowers with poor credit, primarily through a credit-default swaps market created by Wall Street dealers including Lippmann. The investments were a drag on performance as banks repackaged the notes into collateralized debt obligations and inflated demand even as home prices peaked and then foreclosures began soaring.

The fund returned 3.3 percent in 2005 and 5.2 percent a year later, trailing an industry average of 8 percent in 2006, according to documents obtained by Bloomberg.

‘Successful Defense’

“I look at those two years as having played successful defense and having avoided going to the dark side,” Narula said in an interview, referring to managers that added “real estate credit risk at the top of the market.”

Investors lost patience as rivals took on greater risk to boost returns. The fund shrank to about $170 million at the start of 2007 and after five months hadn’t made any money.

Clients became more concerned when two Bear Stearns Cos. funds invested in subprime securities collapsed in June, fueling misgivings about mortgage managers generally and highlighting potential dangers within the financial system.

He decided to liquidate the fund even though Metacapital held trades that would profit the rest of the year, including bets against subprime and commercial-mortgage bonds and wagers on increasing volatility, he said.

He’d been too early shorting subprime and hadn’t committed enough.

“I look back over the last 10 years and that’s the one regret,” Narula said. “Even though we had the right idea, we were just way too early. Timing is everything.”

As he tried to wind down the fund in 2007, Wall Street brokers demanded greater premiums to buy and sell securities and he lost 7 percent that year.

Analyzing Behavior

Narula went back to analyzing borrower behavior almost two decades after gaining a PhD in 1989 from Columbia University’s business school where mortgage-backed securities were part of his studies. He’d enrolled after earning a degree in electrical engineering from the Indian Institute of Technology Kanpur, one of the country’s top universities, where admittance is solely by examination.

After joining Lehman, Narula established himself as one of the leading Wall Street mortgage analysts, eventually running the strategy for the investment bank and getting ranked in Institutional Investor Magazine’s annual survey for three years. His success running a model portfolio that investors followed earned him a move to trading in 1995, Narula said.

What made him unique is that he married a technical background with the ability “to develop and explain his views in a very persuasive way,” said Amitabh Arora, who would join the mortgage-research department that Narula had left two years later.

Trend Spotting

As a trader, he was “always very quick to spot trends, and sometimes much quicker than people who were spending a lot of time on the same question,” said Arora, who oversees Citigroup Inc.’s research on government bonds from the 10 largest economies as well as securitized products.

By 1998 Narula ran several agency-mortgage trading desks for New York-based Lehman, which put him near the front line when a series of global events roiled bond markets.

Then Russia defaulted on its bonds, hedge fund Long Term Capital Management imploded and mortgage investor Ellington Management Group LLC almost collapsed. Lehman, facing daily rumors of insolvency because of its holdings of emerging market debt and commercial mortgages, had to shrink its balance sheet in an illiquid market.

“Every passing storm that has hit the financial markets helps you learn and 1998 really was an eye opener,” said Narula.

Applying Lessons

He left Lehman two years later as the firm moved away from proprietary trading and toward matching trades for investors -- a strategy Chief Executive Officer Richard Fuld reversed during the last credit bubble, leading to its 2008 downfall.

That year, when Metacapital began raising money to manage again, he applied those lessons, including the dangers of buying when the rest of the market has to sell.

He passed as subprime and other non-agency mortgage bonds plunged to less than 30 cents on the dollar, speculating that the number of potential sellers far outnumbered the firepower available to buyers, he said.

In 2009, he more than doubled his investors’ money when he bought non-agency debt once the government created public- private funds to bolster prices. In 2010, he profited by speculating fewer borrowers than investors anticipated would refinance government-backed loans even after changes introduced by Obama. He also bet against debt after the Fed halted its first bond buying program, known as quantitative easing or QE.

Protecting Returns

After non-agency debt prices had soared in early 2011, he sold some of the investments. That protected the fund from declines that hurt rivals when the Fed said it would auction bonds inherited during the rescue of American International Group Inc. and Europe’s debt crisis erupted.

He later targeted loans to borrowers with Fannie Mae and Freddie Mac mortgages that had taken advantage of a program to refinance their debt even when they didn’t have home equity. Those loans were then excluded from expanded Obama administration rules after mortgage rates had dropped, boosting the value of securities that couldn’t immediately prepay.

This year, he also added securities that have risen to record prices after the Fed said in September it would buy to bolster housing and the economy, under QE3.

The success of mortgage strategies has attracted new entrants.

In July, DW Investment Management, which handles some credit investing for Brevan Howard, hired Sean Macleod from Metacapital to expand into government-backed securities. The Brevan Howard Credit Catalysts Master Fund, which has $2.5 billion in assets and is managed by DW’s David Warren, rose 12 percent this year, according to a person familiar with the matter.

The market is getting crowded and investors will eventually need to deal with a Fed that’s tightening monetary policy, which could “absolutely destroy” some managers, said Peter Rup, chief investment officer at Artemis Wealth Advisors LLC.

“We’re in the eighth inning with regards to that opportunity,” said Rup, whose New York-based firm oversees $600 million for high net worth families. “We’re avoiding it.”

Investment Choices

Narula disagrees. He’s seeking to profit from the Fed buying about $75 billion a month in the $5.2 trillion agency bond market, creating price distortions among the different types of securities, the firm wrote in a Sept. 17 letter.

His firm is looking for opportunities to trade on the “specific investment choices” being made by the Fed, which has different goals than private managers, according to the letter. Its buying will affect prices of Ginnie Mae securities relative to Fannie Mae bonds, generic pools relative to specified ones, and the value of 30-year versus 15-year debt.

He’s also adding non-agency securities, the type of bonds that helped fuel the housing bust, his former employer Lehman’s bankruptcy and sent him to the sidelines in 2007.

Now, that debt is gaining along with home prices as the Fed pushes borrowing costs to record lows and the government guarantees about 90 percent of new lending.

“At the start of the year we thought that housing could surprise on the upside,” Narula said. “It looks like this is the year housing turns and that’s largely attributable to actions the government has taken.”

Deepak Narula hit bottom in 2007 when investors pulled money from his hedge fund, leaving him to unwind mortgage bond bets in a frozen market that would have made money if he’d just held on a few more months.